Is Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Equatorial Pará Distribuidora de Energia S.A. (BVMF:EQPA3) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out the opportunities and risks within the BR Electric Utilities industry.

What Is Equatorial Pará Distribuidora de Energia's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Equatorial Pará Distribuidora de Energia had debt of R$4.84b, up from R$4.23b in one year. However, it also had R$2.31b in cash, and so its net debt is R$2.53b.

How Healthy Is Equatorial Pará Distribuidora de Energia's Balance Sheet?

According to the last reported balance sheet, Equatorial Pará Distribuidora de Energia had liabilities of R$2.90b due within 12 months, and liabilities of R$5.90b due beyond 12 months. On the other hand, it had cash of R$2.31b and R$2.39b worth of receivables due within a year. So it has liabilities totalling R$4.10b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Equatorial Pará Distribuidora de Energia is worth R$15.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.93 and interest cover of 6.5 times, it seems to us that Equatorial Pará Distribuidora de Energia is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. On top of that, Equatorial Pará Distribuidora de Energia grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Equatorial Pará Distribuidora de Energia will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Equatorial Pará Distribuidora de Energia recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Equatorial Pará Distribuidora de Energia's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. We would also note that Electric Utilities industry companies like Equatorial Pará Distribuidora de Energia commonly do use debt without problems. Taking all this data into account, it seems to us that Equatorial Pará Distribuidora de Energia takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Equatorial Pará Distribuidora de Energia you should be aware of, and 1 of them shouldn't be ignored.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.